After the Bank of Canada cut interest rates by 50bp this morning, my target of 0.8350 in AUD/CAD has been reached. Yesterday, when the currency pair was trading at 0.8122, I argued that the possibility of the Reserve Bank of Australia leaving rates unchanged and the possibility of the Bank of Canada being more dovish would drive an upside breakout in AUD/CAD.

As for the Canadian dollar, I am still looking for it to fall to 1.30 against the US dollar. The rate decision has already driven USD/CAD to an 11 week high.

As for the Australian dollar, their “surprise” decision to leave rates unchanged should not have been much of a surprise to my readers as we talked about it yesterday. Over the past few weeks, comments from RBA officials have been surprisingly optimistic which should have been a signal for all traders that leaving rates unchanged is an option. Last night, RBA Governor Stevens said that There has already been a major change in both monetary and fiscal policy. The board will consider the position again at its next meeting.” In the RBA’s eyes, they have done alot. They are not closing the door on further rate cuts, but for the time being, they want to give the economy time to absorb the government’s aggressive fiscal and monetary stimulus.

Tuesday’s FOMC meeting will be remembered for decades to come as the Federal Reserve brings interest rates down to the lowest level this generation has ever seen. With 2 realistic options on the table and economist and traders divided on how much the Fed will cut interest rates, the only certain outcome is significant volatility for the currency market. The US dollar is selling off aggressively going into the rate decision as traders realize that after tomorrow, the dollar will either be the lowest or second lowest yielding G10 currency.

No matter how you look at it, an interest rate of 0.50 percent is just as bad as an interest rate of 0.25 percent.

Federal Reserve: 50bp vs. 75bp

The decision of cutting interest rates by 50 or 75bp is really a decision of how quickly the Federal Reserve wants to formally move to Plan B, or Quantitative Easing. If rates are not taken to 0.25 percent tomorrow, then we could see that level reached in the first quarter of 2009. Fed funds contracts are currently trading at 0.15 percent, which means that any rate cut by the Fed will only be symbolic. The futures contracts are pricing in a 74 percent chance of a 75bp rate cut and a 26 percent chance of a 50bp cut, but only 11 out of the 95 economists surveyed by Bloomberg expect interest rates to be cut by more than 50bp. Either way, someone will be proved wrong tomorrow and that could trigger a big move in the US dollar.

Economic data has deteriorated significantly since the last monetary policy meeting and in our opinion, the right thing for the Fed to do is to cut interest rates by 75bp tomorrow and not delaying the inevitable. With the US economy falling into a deeper recession, rationing monetary policy stimulus now could be counterproductive. However, the Federal Reserve may not want to back themselves into a corner by taking interest rates down to 0.25 percent so quickly and therefore many economists argue that a 50bp rate cut is the most likely scenario.

Another reason why the dollar is selling off is because if the Fed eases by only 50bp, they could still signal that interest rates are headed to zero, which would also be negative for the US dollar. The only reason why the dollar could rally following the rate decision would be if the Fed signals to the market that zero interest rates is not a possibility. Unlike Japan, deflation has yet to hit the US and zero interest rates could intensify problems that the repo market and money market funds are already facing. Demand is waning in the repo market as the return is insufficient to cover the risk of failure.

FOMC Statement Needs to Answer 3 Questions

In many ways, the FOMC statement is even more important than the actual interest rate decision. There are 3 questions that the market expects the Fed to answer in the accompanying statement:

1. Are interest rates headed lower?
2. Will interest rates be taken to zero or will we see a BoJ style rate cut that takes interest rates somewhere between 0.25 percent and zero?
3. What is the plan for Quantitative Easing?

Since a full percentage point rate cut is off the table, the Federal Reserve will need to signal whether interest rates will continue to fall and by how much. Although everyone is thinking about rate cuts in quarter point clips, the Fed could take another page out of the Bank of Japan’s book and ease interest rates somewhere between 0.25 percent and zero in March. In other words, 0.15 percent could be the low in US interest rates next year instead of zero. Any hint of this possibility could have a big impact on the currency market. The FOMC statement could also include details for Quantitative Easing. For many people, QE is a new concept that has only one precedent and therefore the Fed may want to offer some transparency.

What Happens After Zero?

When a central bank runs out of room to cut interest rates, they resort to Quantitative Easing. This term was coined by the Bank of Japan in 2001 when interest rates were already at zero and the central bank stopped targeting the overnight call rate and turned to targeting a current account level. Their goal was to flood the Japanese financial system with liquidity by buying trillions of yen of financial securities including asset-backed instruments and equities.

It can be argued that the US has already engaged in Quantitative Easing as the government has recently announce plans to spend $800 billion to unfreeze the consumer and mortgage market. They have agreed to buy mortgage backed securities backed by government sponsored entities and could accelerate that if interest rates hit zero. Excess reserves have also increased significantly, driving the effective fed funds rate well below 0.5 percent. This would have been one of desired outcomes of quantitative easing. Last month, Fed vice chairman Donald Kohn said quantitative easing measures were under review at the central bank as normal contingency planning. The goal would be to encourage banks to lend more aggressively by coming in as a buyer at specified rates. Even though quantitative easing drove Japan into deflation, it was the key to turning around the economy and this is a risk that the US central bank may have to take.

Implications of the Fed’s Rate Decision on Currencies

The weakness of the US dollar against all of the major currencies reflects the market’s expectation that after Tuesday, the US dollar could yield less than the Japanese Yen. If that comes to reality, we could see further weakness in the US dollar against all of the major currency pairs but if the Fed only cuts by 50bp, there could be a violent move in the US dollar depending upon the tone of the FOMC statement.

The following table illustrates how key pieces of US economic data has changed since the last monetary policy meeting. Although consumer confidence has improved and we are beginning to see some upside surprises in US economic data, the trend of most data still points to dollar bearishness.Continue reading

US retail sales and producer prices were basically in line with expectations but that does not undermine the fact that the data was very weak and confirms that the Federal Reserve will be cutting interest rates by 75bp next week. USD/JPY hit a 13 year low last night after news that the automaker bailout plan is not going happen before the new year. Everyone had hoped that the automaker saga would come to an end, but lawmakers are not letting that happen. On Wednesday, I said that USD/JPY could hit to a new 13 year. At that time, the currency pair was trading at 92.50-93.00. The possibility of the US taking interest rates below Japanese levels should keep the US dollar soft going into the Fed interest rate decision on Tuesday.

Consumer spending fell for the fifth month in a row while producer prices dropped for the second straight month. The two biggest inputs into GDP are retail sales and trade. Consumers cut back spending more aggressively in October and November which suggests that GDP growth could take a big dive in the fourth quarter, especially with the widening of the trade deficit.

GDP Could Contract by 4 to 6% in Q4

GDP could decline as much as 4 to 6 percent in Q4, which would be the largest contraction in growth since the 1980s. In the first quarter of 1982, GDP fell -6.4 percent. A 4 to 6 percent drop in GDP would not be out of the ordinary given the current conditions in the US economy. In the fourth quarter of 1990, GDP contracted by 3 percent and in the first quarter of 1991, it contracted by 2 percent. The currrent recession is worse than the one the US economy experienced in the 1990s, so a contraction in growth exceeding 3 percent would actually be expected.

The biggest drop in consumer spending came from gasoline station receipts. Prices at the pump have fallen more than 50 percent since the summer and gas stations are suffering as a result. The only silver lining in the retail sales report is the fact that not every sector saw slower sales. Electronics and sporting goods were in demand but this rebound after at least 4 consecutive months of softer spending is probably related to Black Friday sales.

The US dollar is tanking as jobless claims rise by the largest amount since November 1982, 26 years ago. As I have suspected, it is the 1980s all over again.

This confirms that the 533k drop in non-farm payrolls last month will not be the bottom in the labor market. When claims first hit 573k in January of 1982, non-farm payrolls dropped by -327k. It rebounded significantly the next month (-6k), but that was only precursor to another 10 consecutive months of job losses with non-farm payrolls revisiting the -300k levels in July (NFP in July 1982 was -343k). These jobless claims numbers reflect the massive layoffs that we have heard in the past weeks from companies like AT&T, Viacom and Sony. Continuing claims hit 4.429 million, the highest since 1982.

The widening of the trade deficit leads us to believe that GDP will take a big dive in the fourth quarter. The Treasury market is already pricing in the possibility of deflation and depression with yields in zero to negative territory for the first time since the Great Depression and incoming data supports that thesis.

The weekly jobless claims number will add pressure on the Federal Reserve to cut interest rates by 75bp next Tuesday. Fed Fund futures are already pricing in a 100 percent chance of a 75bp rate cut from the Federal Reserve next week. This would take US rates to 0.25%, making the US dollar the lowest yielding currency in the developed world.

Even though volatility in the currency market has compressed since October and November, the Federal Reserve’s next interest rate decision is a major event risk because interest rates will be taken to historically low levels. Not only are the Fed expected to take interest rates to the lowest level this generation has ever seen but they have to figure out how to effectively signal their intentions of taking US interest rates to zero without completely spooking the markets. This will be a difficult balance to walk and one that could easily lead to an expansion in volatility in the currency market.Continue reading

We are inching closer to a formal bailout plan for the Big 3 automakers and as previously suggested, regardless of the final outcome, the markets will cheer an end to the drawn out drama. The rally in equities this morning have driven major currencies higher against the US dollar and Japanese Yen, but it remains to be seen whether the improvement in investor sentiment will last. We are walking into a lot of potentially weak economic data on Thursday and Friday that could serve as a harsh reminder of the problems that the US economy faces. The PPI and retail sales figures should resurrect concerns that deflation and depression will hit the US.

The Treasury market is already pricing in the possibility of deflation and depression with yields in zero to negative territory for the first time since the Great Depression. Fed Fund futures are pricing in a 100 percent chance of a 75bp rate cut from the Federal Reserve next week. This would take US rates to 0.25%, making the US dollar the lowest yielding currency in the developed world. Although the greenback has remained weak against the Japanese Yen, if the Fed takes interest rates to zero, we could see the dollar fall to 13 year lows against the Japanese Yen.